The U.S. District Court for the District of Maryland granted summary judgment to a mutual fund adviser and its affiliated distributor (collectively, the “Adviser”) in a suit under Section 36(b) of the Investment Company Act of 1940 alleging that the Adviser had breached its fiduciary duty with respect to compensation by allowing various entities to market time the mutual funds it managed (the “Funds”) thereby increasing the advisory fees the Adviser received. The Court found for the Adviser on the grounds that a roughly $19 million offset from the Adviser’s 2004 settlement of enforcement proceedings brought by the SEC with respect to the market timing activity (the “Settlement”) exceeded the amount the plaintiff shareholders could potentially recover under Section 36(b).
The Settlement. Under the Settlement, the Adviser agreed to pay $100 million, consisting of $50 million in disgorgement and $50 million in civil penalties. These amounts were placed in a Fair Fund to be distributed to Fund investors in order of priority for (i) their proportionate share of losses suffered by the Funds due to market timing and (ii) their proportionate share of advisory fees paid by the Funds that suffered losses during the market timing activity, with any amount not distributed to individual investors credited to the Funds themselves. As a result, the Funds received approximately $19 million from the Fair Fund. The Settlement also provided that in a private damages action brought against the Adviser by or on behalf of one or more investors based on substantially the same facts as those addressed in the Settlement, the Adviser could claim an offset only for monies paid under the disgorgement portion of the Fair Fund. The Court had previously granted summary judgment on some of the investor claims against the Adviser based on a $21 million offset for civil liability from the amounts paid into the Fair Fund.
Offset. The plaintiffs argued that because individual investors received $61 million prior to any distribution to the Funds, the entire disgorgement had been distributed before any distribution to the Funds had been made; as a consequence, amounts distributed to the Funds were from the civil penalty portion of the Settlement against which no offset was permitted. The Court rejected this argument because it would force an arbitrary decision about the origin of fungible monies and was not consistent with the rationale for permitting the Adviser to claim an offset for the disgorgement amounts paid into the Fair Fund. The Court noted that granting the Adviser a $19 million offset did not threaten the $50 million deterrent of the civil penalty and avoided any potential windfall for the Funds.
Section 36(b) Standard. The Court noted that courts have adopted two different approaches to determining whether an adviser has violated Section 36(b): either (1) they examine whether an adviser has charged a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s length bargaining; or (2) they examine whether the advisory fee was freely and honestly negotiated on the basis of adequate information disclosed by the adviser. The Court stated that rather than choosing between the two approaches it elected to focus on the issue of scienter, which it had identified as an element of Section 36(b) liability. (The Court acknowledged that it had not found a Section 36(b) case in which the issue of scienter arose, positing that for each of the tests used by courts in Section 36(b) cases, proof of a breach would usually be powerful evidence of an adviser’s scienter.) The Court stated that a scienter requirement for Section 36(b) liability was consistent with a widely recognized goal of Section 36(b): “preventing advisers from obtaining excessive fees by exploiting the fact that a typical mutual fund is captive to its adviser because it is organized by its adviser, managed by its adviser, and unable to easily move from one adviser to another.” The Court also reasoned that allowing recovery under Section 36(b) in the absence of intentional or reckless adviser misconduct would “allow Section 36(b) to be used to de facto challenge the reasonableness of the fees, which is inconsistent with the text and intent of the [sic] Section 36(b).”
Damages. Noting that Section 36(b) permits recovery only for actual damages resulting from an adviser’s breach of its fiduciary duty with respect to compensation, the Court found that the Adviser was liable only for the portion of its advisory fees that were disproportionate, excessive or unearned because they were based upon the existence of market timing arrangements or of insider market‑timed trades not disclosed when the fees were negotiated. The Court found there was no genuine dispute of fact that the Adviser possessed the requisite scienter only with respect to the advisory fees attributable to the market timing activities it intentionally or recklessly permitted, i.e., the advisory fees attributable to the investment in the Funds made by the entities with which the Adviser was found to have entered into market timing arrangements under the terms of the Settlement. The Court found that those advisory fees amounted to $819,541.
Disposition. Because the approximately $19 million offset to which the Adviser was entitled exceeded the $819,541 the plaintiffs could potentially recover under Section 36(b), the Court found that the Funds had been fully compensated and the plaintiffs could not recover any additional damages under Section 36(b). The Court accordingly granted the Adviser’s motion for summary judgment.